The Fed has begun to accelerate its balance sheet shrinkage according to the schedule it set forth last September. Not surprisingly, the effects are beginning to be felt in the markets, just as I had warned. Only the timing was in question, but my technical work took care of that, and it got us heavily short by the time the slide began on Jan. 29, reaching 90% short on Feb. 3.

This balance sheet shrinkage program, which the Fed calls "normalization," actually removes money from the banking system and financial markets. It is the opposite of quantitative easing (QE), so we may as well call it quantitative tightening (QT).

The rate of withdrawal doubled in January and will go up by $10 billion per month every quarter until it hits $50 billion per month in October. If $20 billion a month in QT can cause the kind of damage we saw over the past two weeks, what would $50 billion do? Think about it.

When it comes to the interaction of monetary policy and the financial markets, it is the quantity of money, not the cost of money (interest rates) that matters. Considering that, this "normalization" program isn't "normal" at all. It is the most drastic tightening of money in history.

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The effects of this policy have begun to be felt in the financial markets. Bond yields have been soaring for months, and stock prices have crashed over the past two weeks.

Yields bottomed in September, when the Fed announced the policy, even though it didn't start until October. Then yields started going parabolic in December, a rise which has continued into February. Stocks finally succumbed on Jan. 29. There simply was no longer sufficient liquidity (money) in the system to support the manic blowoff in stock prices.

Wall Street pundits are calling the stock market plunge a "pullback" or a "correction." I say let's call a spade a spade. A 10% drop in prices over two weeks is not a "pullback." It is a crash. And remember, the Fed told us that this program of "normalization" is on autopilot. The Fed has told us that the policy is so set in stone that it refuses to even discuss it or mention it in future FOMC statements. So with Fed policy set to only get even tighter in the months ahead, the type of market action that we've seen in the past two weeks will happen again and again. This pattern won't end any time soon.

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We understood the significance and implications of this momentous Fed policy change even before it was announced in September. I warned last summer that it was coming because the trial balloons had been floated in the media. Even a couple years before that I had warned that when you see the trial balloons about shrinking the balance sheet, it would be time to take the idea of real tightening seriously.

Finally, I wrote right here in the last report on the Fed's balance sheet and banking indicators back in early January: "It hasn't happened yet, but at some point during this period of ratcheting up of the pressure, the stock market should start to roll over."

"At some point" started on Jan. 29. And it won't end any time soon. It calls for a trading strategy of shorting the rallies and an investment policy of, if not being largely short the market, at least being mostly in cash.

A Closer Look at the Fed's "Money Drain" – and How to Profit

Here's an overview of the asset side of the Fed's balance sheet this week, along with my interpretation of some of the implications.

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